The Only Time I’ll Tell You Debt Is Profitable

Keith Fitz-Gerald Mar 18, 2015
25 

The other day I saw an ad for a mattress store that offered financing, so you can “sleep in peace” on your brand-spanking-new $7,000 mattress set. (Talk about irony!)

Debt is the American way. It makes the impossible possible. It’s seen as benign or even good.

It’s not.

Personal consumer debt is one of the most dangerous financial products ever created.

Federal Reserve data show that Americans owe $11.74 trillion as of 2014. Some $882.6 billion of that is credit card debt, $1.13 trillion is student loans, and another $8.14 trillion is mortgages. An estimated 119.3 million indebted households carry an average of $15,257 each, or more than double the $7,117 carried (and paid off monthly) by non-indebted households.

The way I see things, debt is nothing more than “plastic prosperity” that makes you feel like you have more spending power. It’s a myth that’s been sold to the American public methodically and systematically for 30 years. And it wrecks lives.

Getting out of debt (or avoiding it entirely) is an absolute imperative when it comes to building Total Wealth.

But as an investor, there is one instance where you should consider taking on debt.

There’s one instance where debt can even be profitable.

First Thing’s First – Get Debt Out of Your Life

Before I can show you the one way you can use personal debt to your advantage, it’s really important to step back for the bigger picture.

Washington believes personal debt is absolutely essential to the economy, noting repeatedly that both industrial output and employment would suffer if consumer credit diminished. What else would you expect them to say?

But Washington’s got it wrong.

Rising credit usage is a sign that more families have to borrow to make ends meet. It’s not a sign of returning consumer confidence, but proof positive that everything’s getting more expensive.

Critics – and debt proponents – screech that overall debt levels are dropping and that this is a sign that the economy is getting stronger. They’re right on one count… overall indebtedness has fallen from $19,000 per household at the height of the financial crisis to $15,611 as of January.


Click to enlarge

Here’s what they’re missing.

If you look closer, indebtedness is actually decreasing because more people are defaulting instead of repaying what they owe. Charge-offs – that’s what the credit companies call uncollectable debt – rose to 10.9% by 2010, up from 3.1% in 2006. That figure has since fallen back to approximately 3.25%, but only because so many people have already been wiped out of the credit markets.

At the same time, banks tightened lending standards so they restricted credit. This, too, contributes to a drop in overall debt figures.

There has been no structural change in consumer credit whatsoever. The “improving data” the Fed talks about constantly does not reflect fiscal prudence.

Simply put, you cannot encourage prosperity and build sound financial security on borrowed money, even though our government seems to think so.

Except in one instance.

The One Way to Make Debt Profitable

Data shows that 30% of American families own their homes and don’t have to worry about monthly payments to banks.

Props to them! Either they bought their homes flat-out, or they’ve already worked off their mortgage. Either of those things is a wonderful accomplishment.

And if you’re buying a home now?

I get asked a lot about whether it makes sense to pay off a mortgage early at a time when many Americans have refinanced at historical lows or are buying homes at rates that are still artificially low.

I think it comes down to opportunity cost.

Buying a home is that one instance where you do want to use debt to your advantage – but only if you have to, and only if you understand the alternatives.

For example, according to Bankrate.com, the average interest rate in the U.S. for 30-year mortgages is 3.97% (as of the week of March 11). That’s less than one-third of the 12.39% that the S&P 500 returned in 2014 alone, and 58% less than the 9.5% the market has returned on average every year since 1871.

So at the risk of annoying every real estate lender and agent from Portland to San Diego, there’s a good case to be made at the moment that you’re better off investing than buying a home. The former is an asset, the latter a liability that keeps you out of the rental market.

Even so, many people – including me – want to own their home. Going into debt as part of the purchase is a necessary evil, albeit not a hopeless one.

Here’s how to make the process work in your favor…

Three Rules for the One Time You Should Welcome Debt Into Your Life

1) Borrow as little money as possible.

I know this sounds obvious, but it’s not. People get caught up in the home-buying process. They forget that professional realtors are paid on commission based on the purchase price, not how much money you’re going to save. Mortgage bankers are the same way, generally speaking. So it’s in their interest to see you borrow as much money as possible to maximize their fees.

My wife and I recently bought a home and you should have seen the look on my banker’s face when I declined to take more than half of what I was approved to borrow!

Buy a smaller home or move to a less expensive area if you have to. And even if you don’t think you’ll qualify, check into home-buying assistance programs, especially if you’re a first time buyer, a veteran, or active duty military.

2) Don’t touch an Adjustable Rate Mortgage (ARM) unless you are fully prepared to pay it off in no more than 5-7 years.

These little gems are essentially residential versions of the low teaser rates that credit card companies offer as an enticement to sign up. Put bluntly, they’re little more than “bait and switch.”

But watch out. It’s commonly understood that ARMs adjust based on the prime rate or U.S. Treasuries, but they can also be “reset” at a rate that’s not only not always disclosed in advance, but which almost always increases.

In some cases, the low monthly payment you think is great when you sign on the dotted line can rise by 20-30% over just a few years on as little as a 3% interest rate bump. According to the Huffington Post and a 2007 AFL-CIO study, the average monthly increase accounted for 10% of after-tax income.

I’m not sure what that would be today, but with the Fed finally ready to raise rates, I wouldn’t be keen to find out either.

3) Pay off your mortgage as fast as you can.

Many homeowners fail to consider the true cost of ownership. I’ve given more than a few presentations where the audience gasped as I demonstrated why borrowing $250,000 at 4.3% will actually cost $445,384 over the life of the loan.

There are a few ways to do this. For instance, you can make an extra payment every quarter and pay off a 30-year loan approximately a decade early. Or, you can make bi-weekly payments that will shave anywhere from 4-6 years off your mortgage.

My favorite tactic with interest rates as low as they are today is to invest extra money in a choice like the PIMCO Strategic Income Fund Inc. (NYSE:RCS), which yields a stunning 8.6% according to Yahoo! Finance as of press time. Over time, you can use the incremental yield of 4.63% (8.6% yield minus the average 30-year rate of 3.97%) to accelerate your repayment.

Many people are concerned that choices like this will tank if the Fed raises rates, and rightfully so. But I think they’re making a mountain out of a molehill. The Fund’s managers will adjust holdings accordingly, so odds are that there will always be a differential spread you can use to your advantage.

You could also consider investing in a choice like the Williams Companies Inc. (NYSE:WMB), which currently yields 5% according to Yahoo! Finance. As the energy sector rebounds over time (and it will), you’ll have both the appreciation and cold hard cash needed to accelerate your mortgage and boost your wealth at the same time.

Obviously the incremental yield is not as high and there may be tax considerations unique to MLPs, but that does not change my point – you can use the market to fund your pre-payment schedule and help you get out of debt faster.

Especially if you’ve decided to buy a home and borrow money to do it.

Best regards for great investing,

Keith Fitz-Gerald

25 Responses to The Only Time I’ll Tell You Debt Is Profitable

  1. Barry says:

    Morning kieth

    Think there is an old saying that says something to the point that never buy a home that requires u to use all your funds to pay the mortgage debt and not have a life

    U make good points
    ———————————
    BTW between your last update on human augmentaion & report Ekso just Wed. , Ekso came out after the bell yesterday with their 4th qrtr and year end finacials

    Now I look at these as blips on a screen as a company builds for its future and 1 finacial statement doesnt reveal all there is to that compnaies growth & future, especially a small company like Ekso , but i was wondering what u made of it as its really beyond my ability to interpret

    If u havent seen it here is a link as its posted on the website under news releases

    MAR 17, 2015
    Ekso Bionics Reports Fourth Quarter and 2014 Financial Results

    http://ir.eksobionics.com/press-releases/detail/534

    Thanks Barry

    Thanks

    • Roy F. Schoonover says:

      Thanks, Barry. Good info to see.

      Roy F. “Frtiz” Schoonover

      • Keith says:

        Thanks Barry and Roy.

        I’ll take a quick look at Ekso and glad you enjoyed this article.

        Best regards and thanks for being part of the Total Wealth Family, Keith πŸ™‚

  2. Kelly Smith says:

    Keith
    I have been enlightened by an overwhelming amount of information since joining the subscription. I have limited amount of capital every month and I am looking for initial solid investment. What do you recommend of all your choices for a beginner to start building a portfolio. Initial investment will be two thousand. Thanks

    • Keith says:

      Hi Kelly.

      Thank you for the kind words. I will do my best and I am thrilled you are here.

      To your question, the single biggest thing any investor just starting out can do is purchase what I call a “Base Builder.” In the Money Map Report, that’s a choice like the Vanguard Wellington (VWELX). It’s not all that exciting but that’s my point. The surest path to profits is a strong foundation. As you accumulate more capital, you can branch out into Growth and Income then speculative stocks in that order.

      I’ll have columns about all this ahead (and a new book I’m working on, too) that will help explain.

      Best regards and thanks for being part of the Total Wealth Family, Keith πŸ™‚

  3. Richard Malmed says:

    I have to disagree. Currently, I rent a property for $1200 per month which appraises for mortgage purposes at $125,000.
    With the current mortgage rates at 4% or so and taxes and insurance, the monthly morgage payment would be $750 at most.
    Plus the owner would get tax deductions for interest and taxes. The rate of inflation at a minimum would be 2% per year,making home ownership a well leveraged inflation hedge. Making mortgage prepayments or making a larger down payment is essentially investing at 4% in a long term illiquid investment. Take that same money and invest in PIMCO at 8.6% and have a readily available liquid asset.
    For most unsophisticated investors, owning a home and accruing equity is the best way to accumulate wealth and retirement assets. Under normal circumstances over the last 40 years, homeowners have started with a 10% return on their money which is partially sheltered by tax deductions for interest and real estate. The inflation rate of 2% is leveraged with a 20% down payment on a home to be an increase of about 8% per year in the 10% original return plus the reduction in the mortgage principal.
    The more I think about the conclusions drawn in this article the more I see how misguided it is.

    • Charlie says:

      I fully agree with you.

      • Keith says:

        Hi guys.

        You both raise some very valid points. However, you’re both operating on the fundamental assumption that the owner purchased at the present value. Having living through the Japanese real estate crash and seen what’s happened here and in Europe since the Financial Crisis began, there’s a different perspective at hand. Factor in physical improvements, power bills and the like, most of the time the numbers come out even with appreciation over the life of a 30 year mortgage (if you’re lucky). No doubt, there are exceptions but they’re exceptions for a reason.

        Best regards and thanks for being part of the Total Wealth Family, Keith πŸ™‚

  4. Angela Millington says:

    Thanks for the great article. There is a lot of wisdom there and people would be wise to heed what you say.
    Angela M.

  5. Hal says:

    A simple way to use exactly the sme money to reduce your mortage debt faster is to arrange with the lender to pay two times per month instead of one time. So if you pay $1,000 per month pay $500 two times per month. In doing so the interest will only accure for 15 days instead of 30 days. Less interest paid over time equals a paid off home sooner!

    Hal

  6. Pat O says:

    I agree wholeheartedly. Recently refinanced to a 15 year 3.125% mortgage. Meantime, I have all that money invested in dividend growing stocks that offer both dividend and appreciation. And my mortgage interest is deductible at ordinary rates while my dividend and capital appreciation get tax preferential rates.

  7. ryan says:

    A staright shooter with solid advise with no sales pitch.

  8. Connie Bunnell says:

    Thank you! Will send this info to others.

    • Keith says:

      Thanks Pat, Ryan and Connie.

      Glad this resonated.

      Best regards and thanks for being part of the Total Wealth Family, Keith πŸ™‚

  9. Dave says:

    If Richard Malmed is correct, we should all buy as many $125,000 properties as we can and rent them out for $1200. Using his figures, we will have a cash flow on each property of $450 along with marvelous tax benefits. I have a home appraised at $135,000 with a 15-yr mortgage at 3.375%. My mortgage payments are around $1200. Seems I have to insure the place, pay property taxes, and mortgage insurance. Then, of course, there is maintenance. Oh, well… it did sound like easy money the way Richard described it.

  10. Mike Bailey says:

    This is the first time ever I have commented on an article but I am tired of ARM’s getting a bad rap. I emigrated from the UK to US in 1980. In the UK at the time, all mortgages were adjustable rate on a monthly basis and I got caught up in the Paul Volker interest rate hike in the late 1970’s and my mortgage went from 7% to 18% I recall. I have bought 3 houses with ARM’s in the US with substantial down payments and an ARM enabled me to buy more house at the time. So an ARM with a yearly cap of 2% and a total cap of 12% seemed like a good deal given my UK experience especially since it is been less than 3% for ever and is nearly paid off. The point is not that ARM’s are bad per se it is just that banks and people are fiscally irresponsible in the same way that credit cards are useful if you pay them of every month and use the perks.

    • Keith says:

      Boy, I love your style Mike. You hit the nail on the head – it’s people who can’t handle the loans any more than they can handle their credit cards. Well said. And your timing in the meanwhile using ARMs while rates are in decline seems to have been great. Congratulations.

      Best regards and thanks for being part of the Total Wealth Family, Keith πŸ™‚

  11. Michael Clark says:

    w/ regard to your recommendation to RCS and recommendation to help pay off a Mtg sooner, THAT plan is something I’ve been looking into on several of my properties. I’ve noticed that a investment into RCS during the last year would have been a complete loss which brings a few questions: 1. About when would be a good time to invest in that fund? 2. Are there others that might be better or to consider? 3. I’ve heard a good index fund might be a better choice. Are there any that almost always go up where the risk might be less?

  12. Sivaji says:

    Keith,

    I like every suggestion you make for Building wealth. I am in my 40’s never saved much money in cash & Cash flows.

    Like ESKO, Is there any other MLP or REIT’s that would stay in business and grow the money along with some Cash flow.

    Thanks,
    Sivaji

  13. Allen MacDiarmid says:

    I use my credit card every chance I get. I get a 1.5% “reward”, AKA kickback, for all my purchases. I have it set up so it is paid off automatically the last day that it is due and thus am making a much larger profit on my MasterCard than on my savings or checking account. Please don’t tell me this is bad practice. Also my house is paid off, my car is paid off and I have no long or short term debt that costs me anything. Do you agree? Allen

    • Michelle D. says:

      Keith,

      Thanks for all of your great insights and helpful information.

      I just checked this morning about the( VWELX) Vanguard fund and it stated that it was now closed to new investors. Do you anticipate that changing at any point?

      Thanks,
      Michelle D.

  14. Chuck says:

    “1) Borrow as little money as possible.

    I know this sounds obvious, but it’s not. People get caught up in the home-buying process. They forget that professional realtors are paid on commission based on the purchase price, not how much money you’re going to save. Mortgage bankers are the same way, generally speaking. So it’s in their interest to see you borrow as much money as possible to maximize their fees.”

    Barry,

    I am missing your point. A sale price of a home is a sale price and has nothing to do with how much or little a Buyer borrows. So the commission is based on how much a Buyer is will to pay and how much the Seller is willing to sell. Yes, if you purchase a cheaper home the commission is less. If you put 75% into the transaction, the sale price is still the same. Other than that, good article.

    Chuck

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